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Merger Fund Feels Credit Squeeze

This fund took a hit as financing troubles put a damper on the buyout boom, but it still is worthy of consideration.

By Thomas M. Anderson, September 6, 2007

A summer of credit woes has cooled years of merger mania. Defaults in subprime mortgages have sparked a global credit crunch, which has caused many investors to wonder whether a spate of big mergers announced earlier this year will be completed. That could spell trouble for the Merger fund (symbol MERFX), a Kiplinger 25 member that invests in takeover stocks.

The fund's strategy is called merger arbitrage. Here's how it works: The three managers, Fred Green, Roy Behren and Mike Shannon, buy shares of the company being acquired after the takeover has been announced. The target's shares usually jump after the announcement but not all the way up to the deal price.

The spread between the price at which the stock trades and the deal price reflects the risk that the transaction will fail or have to be renegotiated, as well as the time value of money, because there is usually a lag of several months between takeover announcement and consummation of the deal. A takeover can fall through if, for example, regulators block the combination or, more relevant in the current environment, the buyer has trouble obtaining financing for the purchase.

Jitters about pending mergers battered target-company stocks in July and August. As a result, Merger fund and other investors who practice that strategy suffered losses.

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From the market's July 19 peak through its trough on August 16, Merger fund lost 4.7%. Standard & Poor's 500-stock index, by contrast, lost 9.1% over that period. Although Merger fund beat the index, the losses may have surprised some investors who had become accustomed to a fairly smooth ride.

The fund has since rebounded, along with the rest of the market, and, year-to-date through September 5, it had returned 5.7%, about a half of a percentage point ahead of the S&P 500. But skittishness lingers over deals for which private-equity firms need to borrow money.

Leveraged buyouts depend on huge loans arranged by syndicates of banks. Typically, banks sell off slices of debt generated by leveraged buyouts in pools known as collaterized loan obligations, or CLOs. But that market has dried up as income investors have fled to safer debt instruments.

Under the terms of most leveraged buyouts, banks pledge to buy CLOs they do not sell to investors. That means banks could be left holding CLOs on their books, which would hamper them from lending money to finance new deals. "You have a scare, if not a hysteria, surrounding the credit markets when in fact the higher quality banks involved in these debt syndicates are not in dire straits," says Behren, one of Merger fund's co-managers.

Still, banks can weasel out of their existing commitments, which can affect some deals. In August, a bank syndicate renegotiated with Home Depot and a group of private-equity buyers to refinance the sale of HD Supply, the home-supply retailer's wholesale distribution unit, for $1.8 billion less than originally committed.

Behren calls the HD Supply transaction a special case and says that the all the deals the Merger fund currently invests in are not contingent on financing. "In the absence of a material adverse change at the target company, the equity sponsor is contractually obligated to complete the transaction and, for the most part, the banks providing the loan commitments are contractually obligated to fund the transactions," he says.

Competition created by the buyout boom has made it tougher on banks to break commitments, Behren says. In the past, merger agreements allowed banks to back out if the target company's industry slumped or a natural disaster hit.

That's not the case with the batch of agreements struck over the past couple of years. "We don't believe that the banks are going to fall down on their obligations and fail to provide financing," Behren says. "Whether or not the desire is there, the contractual obligation is there."

The trick to merger arbitrage is to pick deals that get consummated. The Merger fund team prefers to buy target-company stocks when the buyer has a strategic interest in making the acquisition, such as buying a rival or a complimentary business, as opposed to buyers who want a company for its underlying assets, such as real estate. "We love strategic transactions because they tend not to be as dependent on financing and quarter-to-quarter performance of the target company," Behren says.

Many of the stocks added to the fund in the second quarter, including CDW (CDWC), First Data (FDC) and Nuveen Investments (JNC), are the objects of private-equity buyouts.

Although it appears as though the number of giant leveraged buyouts will diminish, Behren doesn't see a prolonged drought in M&A activity. Many companies are so flush with cash that they can make acquisitions without having to borrow. Private-equity firms still have billions of dollars they need to deploy. And the globalization of the capital markets means more cross-border deals will come down the pipe, Behren says.

Merger has eked out consistent returns in tough markets. Since its 1989 start, the fund has had only one down year (2002, when it beat the S&P 500 by 16 percentage points). Over the past five and ten years through September 5, Merger returned a respectable 7% annualized. Over the past five years, Merger trailed the S&P 500 by an average of six percentage points per year, but over the decade, it outpaced the index by a smidgen.

In any case, comparing Merger's performance with the stock market's probably isn't fair. It may be better to view this fund as a substitute for fixed-income money. Because the fund often zigs when bonds and stocks zag, Merger can give your portfolio a dose of hedge-fund-like diversification.